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April 21, 2014

Hedge Funds Shake Financial System More Than Banks During Crises: Study

New model accounts for spillover effects among financial institutions

Hedge funds' high leverage means more risk to spread around if they are forced to liquidate.

Hedge funds may play an even bigger role than banks in transmitting financial shocks to the rest of the market, and thus may intensify systemic risk more than previously thought, according to new research.

An economic letter issued last week by the Federal Reserve Bank of San Francisco reported a new risk measurement that suggests that financial crises intensify spillover effects among certain types of financial institutions.

It shows that hedge funds may be the most important transmitters of shocks during crises.

Reint Gropp, a visiting scholar at the San Francisco Fed from Goethe University in Frankfurt, developed a new way to measure spillover effects, and estimated the effects for investment banks, commercial banks, insurance companies and hedge funds.

How big and how long risk spillovers among financial institutions last depend on whether markets are in normal times or in crisis, Gropp reported. They can be much larger during crisis times.

He found that insurance companies — the case of AIG during the recent financial crisis notwithstanding — are not systemically important in causing distress elsewhere. They tend to be relatively safe in crises, as their returns are negatively correlated to those of other institutions.

In contrast, spillovers from hedge funds during crises become huge, and make the funds more important shock transmitters than either commercial or investment banks.

The reason is that hedge funds are opaque and highly leveraged, Gropp said. If forced to liquidate under duress, they may sustain big losses, possibly leading to further defaults or threatening systemically important entities both directly as counterparties or creditors and indirectly through asset price adjustments.

How big are the spillover effects from hedge funds? Gropp said that during normal market conditions a one percentage-point increase in hedge fund riskiness raises risk of investment banks by an estimated 0.09 percentage point.

During crises, the same shock increases the risk of investment banks by 0.71 percentage point.

By comparison, a one percentage-point increase in risk of commercial banks leads to a 0.01 percentage-point increase in risk of investment banks during normal times, and a 0.05 percentage point increase during crises.

Hedge fund spillover effects are largest after 10 to 15 days, and subside after about three months, according to Gropp.

He said more research is needed to explain the mechanisms that underlie the estimated spillover effects.